Analysis

Theoretical Approaches to the
Economics of Pricing Under Differing Market Structures

In a pure monopoly, a variety of price structures may be
consistent with cost recovery, and the firm (or regulators) may be
able to select price structures that promote political or social
goals such as universal service or unbundling of raw transport. In
a competitive market, this flexibility may not exist. Under perfect
competition (which assumes no barriers to entry and many small
firms), the price per unit will be equal to the cost per unit
(where costs are defined to include the opportunity costs of all
resources, including capital, that are used in production). There
is no pricing flexibility. When neither of these pure market forms
exist, economic theory does not provide any general conclusions
regarding equilibrium price structures or industry boundaries.
While substantial progress has been made in developing game theory
and its application to oligopoly,3
no completely general results on pricing are available. This is
particularly true in the dynamic context where interdependencies
between current and future decisions are explicitly considered.
Some theoretical work in this area is summarized in Shapiro.4 An important result in game theory
asserts that no general rules can be developed: "The best known
result about repeated games is the well-known 'folk theorem.' This
theorem asserts that if the game is repeated infinitely often and
players are sufficiently patient, then 'virtually anything' is an
equilibrium outcome."5 Modeling
based on the specific features of the telecommunications industry
may therefore be a more promising research strategy.

The economic analysis of competition among network service
providers (NSPs) is further complicated by the presence of
externalities and excess capacity. Call externalities arise because
every communication involves at least two parties: the
originator(s) and the receiver(s). Benefits (possibly negative) are
obtained by all participants in a call, but usually only one of the
participants is billed for the call. A decision by one person to
call another can generate an uncompensated benefit for the called
party, creating a call externality. Network externalities arise
because the private benefit to any one individual of joining a
network, as measured by the value he places on communicating with
others, is not equal to the social benefits of his joining the
network, which would include the benefits to all other subscribers
of communicating with him. Again, the subscription decision creates
benefits that are not compensated through the market mechanism. It
has been argued that the prices chosen by competitive markets are
not economically efficient (in the sense of maximizing aggregate
consumer and producer benefits) when externalities are present.6

It has also been argued that "[i]ndustries with network
externalities exhibit positive critical massi.e., networks of
small sizes are not observed at any price."7 The consequent need to build large
networks, together with the high cost of network construction
(estimated by some to be $13,000 to $18,000 per mile for cable
systems8), implies the need for
large investments in long-lived facilities. The major cost of
constructing fiber optic links is in the trenching and labor cost
of installation. The cost of the fiber is a relatively small
proportion of the total cost of construction and installation. It
is therefore common practice to install "excess" fiber. According
to the Federal Communications Commission, between 40 percent and 50
percent of the fiber installed by the typical interexchange
carriers is "dark"; the lasers and electronics required for
transmission are not in place. The comparable number for the major
local operating companies is between 50 percent and 80 percent. The
presence of excess capacity in one important input is a further
complicating factor affecting equilibrium prices and industry
structure.

To summarize: a full economic model of the networking
infrastructure that supports the NII would need to account for at
least the following features:

•

Oligopolistic competition among a few large
companies that invest in the underlying physical communications
infrastructure;

•

Network and call externalities at the virtual
network level; and

•

Large sunk costs and excess capacity in underlying
transmission links.

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